Small Business Structure: LLC vs Incorporation

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Man choosing between LLC or Inc. - LLC or Incorporation. Which one is better for you?
Steve Thompson
Steve Thompson
December 15, 2020
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Legal

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Every new startup's owner must decide on a company structure, such as a small or large corporation, a Limited Liability Corporation (LLC), or other options determined by the state. Weighing the pros and cons of appropriate structures will help an entrepreneur make an effective decision. Here's a look at choosing between an LLC or Inc for small business.

Easy Filing Process for LLCs

It's easier to form an LLC than a corporation due to much less paperwork. Filing articles of organization is the primary requirement in most states to launch an official LLC. This application process through the Secretary of State's office can begin online in some states. Another step some states require is for the applicant to file a public notice to be published in a local publication. Overall, LLCs have minimal requirements compared with corporations.

LLCs Protect Personal Assets

Limited Liability Company

One of the major reasons entrepreneurs decide to structure their businesses as LLCs is to protect personal assets against lawsuits. Like corporations, LLCs protect the personal wealth of owners in the event of litigation against the company. Forming as an LLC further helps owners limit liabilities on company debts and obligations.

A sole proprietor further risks losing valuable personal assets if he or she does not have insurance when a customer or partner decides to launch a heavy lawsuit. Startups can collapse overnight without forms of risk management. Meanwhile, corporate and LLC owners are shielded with protection that prevents assets such as homes and cars from getting seized and liquidated by creditors.

But in some cases when an LLC is automatically dissolved, such as for failing to file on time, members may face risks. Other ways an LLC can automatically dissolve are when a member dies or withdraws without a succession plan in place. An LLC may also face a technical termination when 50 percent of the company's total interest or profits is transferred within a 12-month period.

Elevated Credibility

Another reason to become an LLC is to boost the firm's credibility in the business community. The extension "LLC" after a name has a similar impact as adding "Inc." It creates the impression of a broader, more viable, and authoritative operation. Furthermore, from a reputation management point of view, this perception is particularly important among colleagues who seek business partners. Many established businesses prefer to work with an Inc or LLC. Not all corporations use the extension "Inc" after their names. Many alternately use entities such as "Co" or "P.A."

Why Corporations are Different Than LLCs

Employees holding the word "Corporate"

The two different types of corporations are S and C, which is the most common type of corporation. An S corporation can pass profits and losses onto shareholders and isn't required to pay a corporate tax. Meanwhile, a C corporation pays a corporate income tax, which is separate from the personal income taxes owners pay. That means owners are double-taxed. C corporations have the option of paying shareholders tax-free dividends if they comply with regulations.

One of the primary drawbacks to becoming a corporation is the heavy load of paperwork and government compliance involved. The firm must elect a board of directors and stage an annual shareholder meeting. The board oversees the officers who run the company and votes on critical company decisions. While an LLC isn't required to have formal officer titles, a corporation has specific officer titles such as CEO with defined roles and responsibilities. In that sense, LLCs have a much more flexible structure than corporations.

Tax Concerns

Person doing their taxes

Owners of an LLC report profit and loss statements from the business on their own income tax returns. Alternately, an LLC has the option to be taxed as a corporation. Owners of a corporation, by contrast, are taxed twice at the individual or corporate levels, unless the company is approved for Subchapter S tax status.

Both an Inc and LLC are allowed to deduct business expenses such as salaries prior to dividing income among owners. So while a corporation must pay taxes, LLCs themselves do not. LLC members, however, must pay self-employment tax, which includes 12.4 percent tax for Social Security and 2.9 percent tax for Medicare.

The IRS treats LLCs in two ways depending on the number of members. If the LLC is owned by just one member, the IRS treats the business like a sole proprietorship when it comes to taxes. But if the firm has multiple members, the IRS treats the business as a partnership. Regardless of how many players are on the team, each member pays their own tax on their individual income tax returns.

LLC and Inc Similarities: Ongoing Existence

One of the qualities that Incs and LLCs share is perpetual existence, as the firm is not dependent on certain personnel staying with the company. What makes both types of business structures unique from a sole proprietorship is that when a sole owner dies it ends the business unless it's left to heirs. But when it comes to closing the business, an LLC is easier than a corporation to dissolve and transfer assets out of the company.

Deciding Between an Inc and LLC

LLC (Group of people) vs Inc. (Corporate Building)

Every business is unique by virtue of having an original founder or set of founders with a shared company vision for targeting a market niche. Incorporating a business is an effective solution for a large operation that needs to raise millions of dollars. But running a corporation is very complex as it must comply with a multitude of federal and state regulations. Corporations are required to operate in very formal ways, such as issuing annual financial reports.

Smaller companies don't have to worry as much about those complexities if they file as LLCs. For startups that plan on investing in the business more than earning profits, an LLC is an easier and more seamless route to take for tax purposes. An LLC, unlike a corporation, isn't required to keep a balance sheet. But an LLC is a good start for a startup that intends to eventually grow into a large publicly-traded company. While a company cannot be both an LLC or Inc at the same time, it can convert from one to the other through a government process.

Conclusion

Deciding on the best company structure for a business startup comes down to examining available resources and the competitive market landscape. The main factors to consider involve limited liability protection, management and control responsibilities, funding options, and tax consequences.

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